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One of our colleagues recently called with a question about the tax treatment of settlement agreements that contain confidentiality provisions.
Apparently, the IRS is trying to capture some of the money that has been changing hands in settlements that are treated confidentially. Although the portion of the settlement payment made in compensation for personal injuries is not taxable, amounts paid to “buy” a confidentiality agreement might be taxable. The IRS assigns some value to the confidentiality provision and then taxes the recipient of the benefit. Because the plaintiff fears being taxed on the value of the confidentiality provision, the plaintiff asks the defendant (in one of several ways) to share that risk.
We personally haven’t settled many cases recently, so we weren’t aware of this issue. In a couple of seconds of research on the web, however, we found this analysis, which looks to be pretty thoughtful. The case that started this controversy was Amos v. Commissioner of Internal Revenue (Dec. 1, 2003) No. 13391-01. It’s an interesting issue, but we don’t think it’s likely to play a big role in the settlement of product liability cases.
So far as we can tell (and we ain’t tax lawyers by a long shot), no later case or IRS ruling has cited Amos. That’s striking, because the IRS watches developments in this area closely because of the number of taxpayers involved and is usually quick to apply any pro-IRS result as widely as possible.
Moreover, the IRS recently adopted a pro-plaintiff (that is, no taxation of sums allocable to confidentiality provisions) position in the clergy abuse cases — cases in which the plaintiffs had difficulty establishing that their injuries, many of them alleged to have been sustained decades earlier, were physical injuries. The result may have been different in Amos because there was much more than confidentiality at stake for the defendant (Dennis Rodman), including the dropping of criminal charges, and because there seemed to be real doubt on the part of the Tax Court as to the extent of Amos’s actual physical injuries.
But that’s a quick take from two guys who couldn’t spell IRS if you spotted us a letter.
For real tax advice, talk to a real tax lawyer.